Simply Beating Earnings is Not Enough

This article was originally published by Zacks.com.

Earnings season can be tough on your portfolio. But what if there was a method to avoid most of the pain and, at the same time, set you up for big gains?

Too good to be true, right? Wrong!

There is a key concept that can help find these stocks that tend not to disappoint. More than that, these stocks prosper.

The range of outcomes

Holding a stock through an earnings report is risky business. It can be the time when the stock jumps higher, or it can be the time when investors kick it to the curb. Those wild swings can give you gray hair (if you still have it) or, worse yet, an ulcer.

Let's explore the meets, the beats and, of course, the raises too.

When a company reports an "inline" quarter, the market will usually shrug its shoulders and the stock will barely move. I like to think of this sort of event as a "lucky they didn't miss" in the wide range of outcomes. It's not as bad as an all-out miss, but it's not much better. That is the meet.

Beating the number

A beat is something we all want to see and, quite frankly, this is pretty common. Why is it common? Corporations have learned that guiding below where they know the result will be is a great tool to boost the stock price. They know the game and what it takes to set the bar nice and low.

But a beat is really only good when it comes on both ends. What I mean by that is a beat on the bottom line with only a light top line draws too many questions. Was there a one-time "honey pot" or accounting trick that helped them beat? It just isn't the same.

Worse still is a beat on top and a meet or miss on bottom. This is an indication that margins have compressed, and I cannot think of a good reason for that. Often times, that is the sort of miss that will carry large multiple declines. Only the shorts win on a scenario like that.

Raise the roof

Without a doubt, the best thing that can happen in an earnings report is for management to raise guidance. I have seen reports that miss by dozens of cents, but when they raise guidance, the EPS number for the previous quarter might as well be ancient history.

The idea is that you own a stock for what it will do, not for what is has done. The increase of expectations by management is a clear indication that the company is doing better. This is what we want to see as investors.

The best case scenario is the beat and raise. This is the sweet spot of earnings season that will help propel your stock higher and higher. It's not only the one time pop that you get from the report, but you also get a solid post earnings drift higher.

The real deal

More often than not, a company that produces a big beat while increasing guidance at the same time gets special treatment. The treatment I speak of is generally an increase in the earnings multiple that investors use to value the stock.

So not only do they get credit for more "E" in the old P/E equation, they also get a boost off that number you multiply "E" by to get "P." This isn't alphabet soup; it's the basic formula that investors use to value stocks. "P" equals price and "E" equals earnings. When we divided the "P" by the "E", we get an earnings multiple.

Moving that multiple higher ends up accelerating the growth of the stock price. Just reading that line should almost bring a little foam to your mouth, I know it does mine. Think about it this way: topping expectations last quarter was great, but knowing you would beat Wall Street expectations for the coming quarter is even better, and you let them know it too!

Movin' on up

Finding companies that don't miss isn't difficult given the fact that most beat. The tough part is finding those that are raising guidance. There isn't really a roadmap or tell-tale sign to let you know which companies are going to beat and raise. One thing I have learned is to look to the big boys for clues.

Following the increases and decreases in CapEx of the biggest companies will give you some clues as to who is going to have success in the future. The more Google spends on fiber, the better it is for their suppliers. The more cars Ford sells, the better it will be for their key suppliers.

Once you hear which sector is seeing increases in CapEx, or which company is dominating the other big boys and girls in their industry, your job is mostly done. The next step is to look at their suppliers. Then look for the suppliers that have been beating the number with some consistency. They are the ones that beat it and raise it.

Brian is the Aggressive Growth Strategist with Zacks.com and provides commentary and recommendations for the Zacks Breakout Growth Trader.

The information supplied above by Zacks Investment Research Inc. contains opinions based on factual research which may or may not be accurate. Neither Zacks nor Intellisphere will assume any liability for losses from investment decisions based on this information.